Thursday, July 12, 2007

I received a few emails asking me to explain what the Average True Range is so I decided to write the following post along with a couple of charts.

True Range is the greatest of the following three values:

The distance from today's high to today's low. The distance from yesterday's close to today's high. The distance from yesterday's close to today's low.

True range differs from range because true range includes any overnight gap that may take place from one day to another.. For example you can have a stock that has a daily range of 50 cents, so the average range over 10 days would be 50 cents.

Now lets say that same stocks gaps up or down over a dollar just about every day. The range for this stock over 10 days will still be .50 but the true range for this stock will be 1.00 because of the gaps.

As a trader I want to know about such gaps because I need to be aware of how volatile a stock really is so that I can place my stops accordingly.

Average true range is simply an average of the true range. In my experience anywhere from 5 to 14 days is usually a good measurement to use when trying to determine a stock's volatility...I like to use 10 days.

The reason why I use average true range in calculating my stop loss orders is because volatility represents market noise. Average True Range (ATR) is a way of measuring volatility and what I do is take a percentage of that value and subtract it or add it from my entry price depending if I am long or short. By doing so, I’m probably going to have set my stop loss order beyond the immediate noise in the market. This is why I use ATR in my trading because it adapts to the current volatility.

So for example....if I am long and I want to place a stop loss order, I would look at the current ATR and use maybe 1.5 times that value subtracted from my entry price. This means the market would have to move more than it's average daily range including its average daily gap to stop me out.

We just looked at how ATR is used for stop placement, now I'd like to show you another little way of using ATR.

Above is a chart of the dow jones Industrials with the 10 day ATR in the lower pane. What I have noticed is that high ATR readings (high volatility) usually takes place at market bottoms for the stock market. Of course I wouldn't use ATR alone to forecast a bottom in the dow jones industrials, but it's something that is worth following combined with other trading methods. What I find interesting is how the ATR just shot up to a high level just prior to the current rally in the market.

Below is a chart of the commodities index (CRB) with the average true range in the lower pane. We can use ATR on commodities too but it's the complete opposite of stocks! Yes you read that correctly. Stocks tend to get more volatile at market bottoms whereas commodities tend to get more volatile at market tops!

This particular timeframe isn't the best example I could have chosen but you can see that volatility increases at market tops not bottoms. Just look at any chart of the grains, cotton, sugar or coffee etc...All of their tops are accompanied by high volatility.. At commodity lows we see low volatility whereas stocks will have high volatility.

So there you have it...This is how I use the average true range in my trading...I hope this helps.

Thks. Whta i the red line drawn through 120? So in the case of DIA, your stop would have been 1.3x 1.5 =1.95 on Monday 7/9? Avery tight stop, I assume. Do you apply this for indinvidual stocks too or you use a higher factor?

I learned much from Chuck LeBeau. Here he shares some of his sentiments concerning Average True Range:

Average True Range by Chuck LeBeau

Average True Range is an indispensable tool for designers of good trading systems. It is truly a workhorse among technical indicators. Every systems trader should be familiar with ATR and its many useful functions. It has numerous applications including use in setups, entries, stops and profit taking. It is even a valuable aid in money management.

The following is a brief explanation of how ATR is calculated and a few simple examples of the many ways that ATR can be used to design profitable trading systems.

How to calculate Average True Range (ATR).

Range: This is simply the difference between the high point and the low point of any bar.

True Range: This is the GREATEST of the following:1. The distance from today's high to today's low, or2. The distance from yesterday's close to today's high, or 3. The distance from yesterday's close to today's low

True range is different from range whenever there is a gap in prices from one bar to the next.

Average True Range is simply the true range averaged over a number of bars of data.

To make ATR adaptive to recent changes in volatility, use a short average (2 to 10 bars). To make the ATR reflective of "normal" volatility use 20 to 50 bars or more.

Characteristics and benefits of ATR.

ATR is a truly adaptive and universal measure of market price movement.

Here is an example that might help illustrate the importance of these characteristics:

If we were to measure the average price movement of Corn over a two day period and express this in dollars it might be a figure of about $500.00. If we were to measure the average price movement of a Yen contract it would probably be about $2,000 or more. If we were building a system where we wanted to set appropriate stop losses in Corn and Yen we would be looking at two very different stop levels because of the difference in the volatility (in dollars). We might want to use a $750 stop loss in Corn and a $3,000 stop loss in Yen. If we were building one system that would be applied identically to both of these markets it would be very difficult to have one stop expressed in dollars that would be applicable to both markets. The $750 Corn stop would be too close when trading Yen and the $3,000 Yen stop would be too far away when trading Corn.

However, let's assume that, using the information in the example above, the ATR of Corn over a two day period is $500 and the ATR of Yen over the same period is $2,000. If we were to use a stop expressed as 1.5 ATRs we could use the same formula for both markets. The Corn stop would be $750 and the Yen stop would be $3,000.

Now let's assume that the market conditions change so that Corn becomes extremely volatile and moves $1,000 over a two day period and Yen gets very quiet and now moves only $1,000 over a two day period. If we were still using our stops as originally expressed in dollars we would still have a $750 stop in Corn (much too close now) and a $3,000 stop in Yen (much too far away now). However, our stop expressed in units of ATR would adapt to the changes and our new ATR stops of 1.5 ATRs would automatically change our stops to $1500 for Corn and $1500 for Yen. The ATR stops would automatically adjust to the changes in the market without any change in the original formula. Our new stop is 1.5 ATRs the same as always.

The value of having ATR as a universal and adaptive measure of market volatility cannot be overstated. ATR is an invaluable tool in building systems that are robust (this means they are likely to work in the future) and that can be applied to many markets without modification. Using ATR you might be able to build a system for Corn that might actually work in Yen without the slightest modification. But perhaps more importantly, you can build a system using ATR that works well in Corn over your historical data and that is also likely to work just as well in the future even if the nature of the Corn data changes dramatically.

BULLETIN Vol. 1 Number 11 Oct. 28, 1998

Average True Range: Article #2

This is the second in a series of articles about using Average True Range. In our first article in Bulletin 10 we explained how ATR is calculated and gave an overview of its many uses and benefits. In this article we will show some specific examples of how using ATR can help to make our systems more robust.

First let’s look at a simple buy only system for Corn without using ATR. Here are the rules:

1. Buy Corn whenever it rises 4 cents per bushel from the opening price. 2. Take a profit whenever the profit reaches 18 cents per bushel. 3. Take a loss whenever the loss reaches 6 cents per bushel.

Now lets build the same system using ATR. (Assume that the 20 day ATR is 6 cents).

1. Buy when the price rises 0.666 ATRs from the open. 2. Take a profit when the profit reaches 3 ATRs. 3. Take a loss whenever the loss reaches 1 ATR.

We have the original system and a modified version that has substituted ATR for the important variables. The two systems appear to be almost identical at this point. They both will enter and exit at the same prices. Now let's assume that the market conditions change and the Corn market becomes twice as volatile so that the ATR is now 12 cents per day instead of 6 cents. Here is a comparison of the original system and the ATR system:

1. The original entry of 4 cents per bushel from the open is now too sensitive. It will generate too many entry signals since the daily range is now 12 cents instead of only six cents.

However, the entry expressed as 0.666 ATRs will adjust automatically and will now require the price to move 8 cents per bushel to enter. The frequency and reliability of our entries remains the same as before.

2. The original profit objective of 18 cents per bushel is much too close for a market that is now moving 12 cents per day. As a result the profits will be taken too quickly and our original system will be missing many opportunities to make much bigger profits than usual.

However the profit target expressed as 3 ATRs has automatically expanded the profit objective per trade to 36 cents per bushel. Significantly larger profits are now being realized by the ATR system as a result of the increased volatility.

3. The original stop loss of 6 cents per bushel will now be hit frequently in a market that is moving 12 cents per day. If you combine these frequent stop loss exits with the overly frequent entries being generated, you have a classic “whipsaw” situation and we can expect to encounter a severe string of losses. Our original system is now failing because the market conditions have changed. We need to fix it or abandon it in a hurry.

However let's look at our ATR version of the system. The stop loss expressed as 1 ATR now sets our stop farther away at 12 cents so it isn’t being hit any more frequently than before. We continue to have the same percentage of winning trades only the winning trades are much larger than before thanks to an increased profit objective. Our ATR system has a nice series of unusually large winning trades and is currently making a new equity peak. The ATR system now looks better than ever.

In our example, the proper application of ATR has made the difference between success and failure.

In our next bulletin we will look at a few more of the many ways we can apply ATR in our trading systems.

*********

Average True Range—Article #3

This is the third in a series of articles about using Average True Range. In our first article in Bulletin #10 we explained how ATR is calculated and gave an overview of its many uses and benefits. In Bulletin #12 we showed some specific examples of how using ATR can help to make our systems more robust. In this Bulletin we will show some of our favorite applications of ATR as part of our entry logic.

Sample Applications of ATR as an entry tool:

Entry Setups: (Remember, entry setups tell us when a possible trade is near. Entry triggers tell us to do the trade now.)

Range contraction setup: Many technicians have observed that big moves often emerge from quiet sideways markets. These quiet periods can be detected quite easily by comparing a short period ATR with a longer period ATR. For example if the 10 bar ATR is only .75 or less of the 50 period ATR it would indicate that the market has been unusually quiet lately. This can be a setup condition that tells us an important entry is near.

Range expansion setup: Many technicians believe that unusually high volatility means that a sustainable trend is underway. Range expansion periods are just the opposite of the range contraction periods. Range expansion periods can be measured by requiring that the 10 bar ATR be some amount greater than the 50 period ATR. For example the 10 bar ATR must be 1.25 or more times the 50 period ATR.

If you are concerned about the apparent contradiction of these two theories we could easily combine them. We could require that a period of low volatility be followed by a period of unusually high volatility before looking for our entry.

Dip or rally setup: Let’s assume that we want to buy a market only after a dip or sell it only after a rally. We could tell our system to prepare for a buy entry whenever the price is 3 ATRs or more lower than it was five days ago. Our setup to sell on a rally would be that we want to sell short only when the price is 3 ATRs or more higher than it was five days ago. The choice of 3 ATRs and five days is simply an example and isn’t necessarily a recommended choice of parameters. You will have to figure out the proper parameters on your own depending on the unique requirements of your particular system.

Entry Triggers:

Volatility Breakout: This theory assumes that a sudden large move in one direction indicates that a trend in the direction of the breakout has begun. Normally the entry rule goes something like this: Buy on a stop if the price rises 2 ATRs from yesterday’s close. Or sell short on a stop if the price declines 2 ATRs from the previous close. The general concept here is that on a normal day the price will only rise or fall 1 ATR or less from the previous close. Rising or falling 2 ATRs is an unusual occurrence and indicates that something out of the ordinary has influenced the prices to cause the breakout. The inference is that whatever caused this breakout has major importance and a new trend is beginning.

Some volatility systems operate by measuring the breakout in points rather than units of ATR. For example the system may require that the Yen must rise 250 points from the previous close to signal a breakout to the upside. Systems measuring points rather than units of ATR may need frequent reoptimization to stay in tune with current market conditions. However, breakouts measured in units of ATR should not require reoptimization because, as we previously explained, the ATR value contracts and expands with changing market conditions.

Change in direction trigger: Lets assume that we want to buy a dip in a rising market. We combine the dip or rally setup described above with an entry trigger that tells us the dip or rally may be over and the primary trend is resuming.

The series of rules might read something like this: If the close today is 2.0 ATRs greater than the 40 day moving average (this condition establishes that the long term trend is still up) and the close today is 2 ATRs or more below the close seven days ago (this condition establishes that we are presently in a dip within the uptrend) then buy tomorrow if the price rises 0.8 ATRs above today's low. This entry trigger shows that we have rallied significantly from a recent low and that the dip is probably over. As we enter the trade the prices are again moving in the direction of the major trend.

As you can see, the ATR can be a most valuable tool for designing logical entries. In our next article we will discuss using ATR in our exit strategies and give some interesting examples.

That’s all for now.

Good luck and good trading

Chuck

BULLETIN Vol. 1 Number 14 Nov. 17, 1998

Using Average True Range for Exits

This is the fourth in a series of articles about using Average True Range. In our first article in Bulletin #10 we explained how ATR is calculated and gave an overview of its many uses and benefits. In Bulletin #12 we showed some specific examples of how using ATR can help to make our systems more robust. In Bulletin #13 we showed some of our favorite applications of ATR as part of our entry logic.

In this Bulletin we will show how ATR can help us achieve more accurate exits.

ATR EXIT TARGETS: Perhaps the most valuable of all the applications of ATR is to use it to define profit objectives. If we were to run some tests to define profit objective in terms of dollars we could probably find a particular dollar amount that produced acceptable results when reviewing historical data. Just as an example, let's assume that we run some optimizations to find the best level at which to take profits in a particular market and we find that the best number is $1250. Although this amount may produce acceptable results on a historical basis it is not always the best solution to the problem.

When the market is quiet and there is little volatility our profits are likely to fall well short of our $1250 objective. However when the market is volatile and trending strongly our potential profit might be much greater than $1250. The $1250 level is simply a not so happy medium that is usually either too large a target or too small a target.

On the other hand if we measure our profit objective in terms of ATR we have a much more robust and logical solution. Let's assume that we run our tests again looking for units of ATR instead of dollars. Assume our research shows us that our best profit objective is now expressed as 4 ATRs. In a normal market 4 ATRs might be equal to $1250, the same as our dollar denominated target. However in a quiet market 4 ATRS might only be $800. The advantage of our ATR research is that while our original $1250 target is no longer obtainable because of the quiet market conditions the ATR target has adapted to the change in volatility and can still be achieved.

Increases in volatility produce an even more dramatic effect. Let's assume that the market is suddenly streaking in one direction because of some important news. Our 4 ATRs is now $5,000. Wouldn’t it be a shame if our system was taking profits of $1250 when the market is willing to give us $5,000 or more?

In addition to setting profit objectives, ATR can also be very helpful in placing trailing stops. Here are two examples that you may recall from discussions on the FORUM page and past BULLETINS.

THE CHANDELIER EXIT: We have often advocated the importance of good exits and this is one of our favorites. The exit stop is placed at a multiple of average true ranges from the highest high or highest close since the entry of the trade. As the highs get higher the stop moves up but it never moves downward.

Examples:

Exit at the highest high since entry minus 3 ATR on a stop.

Exit at the highest close since entry minus 2.5 ATR on a stop.

Application: We like the Chandelier Exit as one of our exits for trend following systems. (The name is derived from the fact that the exit is hung downward from the ceiling of a market.)

This exit is extremely effective at letting profits run in the direction of a trend while still offering some protection against a major reversal in trend. In fact our research has shown that this exit is so effective that you can enter futures markets at random and if you use this exit the results over time will be profitable. (If you don't believe us just try it.) When used for long term trend following the best values for the ATR in most markets ranges somewhere between 2.5 and 4.0.

THE YO YO EXIT: This exit is very similar to the Chandelier Exit except that the ATR stop is always pegged to the most recent close instead of the highest high. Since the closes move higher and lower, the stop also moves up and down (hence the Yo Yo name). Although this stop appears similar to the Chandelier Exit the logic is quite a bit different. The Yo Yo Exit is a classic volatility stop that is intended to recognize an abnormal adverse price fluctuation that occurs in one day. This abnormal volatility is often the result of a news event or some important technical reversal that is likely to signal the end of a trend. This logic makes the YO YO exit very effective and we seldom regret being stopped out whenever this exit is triggered.

We should caution you that the Yo Yo stop should never be our only loss protection because if the price moves slowly against our position the Yo Yo stop also moves away each day and, in theory, the stop may never be hit.

Combining the exits: The Yo Yo and the Chandelier exits work best when used together. The Chandelier Exit is typically set at 3 ATRs or more from a high point and never lowered; therefore it will protect us against any gradual reversal of trend. The Yo Yo exit is typically set at only 1.5 to 2.0 ATRs from the most recent close and will protect our position from unusual one day spikes in volatility. When used together the operative stop each day would be whichever of the two stops is closest.

Here LeBeau addresses Larry William’s objection that in extraordinarily volatile conditions and an ATR based stop could give you a gargantuan loss without combining it with a worst case money management stop.

Money Management Advice: When using any stops based on multiples of ATR we should keep in mind that volatility can quickly expand to where our risk is greater than we intended. We do not want to unknowingly exceed the risk limitations dictated by our money management scheme so we should also have a "worst case" dollar based stop available or be prepared to reduce our position size quickly as the ATR values expand.

When should we reduce our position size and when should we implement our fixed dollar stop?

If we are on the right side of the volatility expansion it may not be wise to reduce our position size just as the trade is beginning to do what we hoped for. For this reason I prefer to implement the dollar based stop on profitable positions rather than reducing the size of winning positions prematurely. We obviously want to have big positions in our winners and small positions in our losers. Therefore it would make sense to reduce our position size only if the volatility is increasing in a trade that is going against us. Once extremely large profits have been achieved, positions can safely be reduced without sacrificing too much in the way of potential profits.

By now we hope you have begun to appreciate the value of ATR in designing systems. There are still more uses for ATR that we have yet to discuss (Keltner Bands for example). We hope to have additional articles about ATR sometime in the future. In the meantime we hope this series of articles has stimulated some creative thinking about the many uses of ATR. Lets us know if you come up with more creative ideas on how to apply this wonderful technical tool.

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